SARs or Options in Closely Held Companies?

If you have a closely held company, which is better, stock appreciation rights (SARs) or stock options? Options are still the most popular choice, but consider some downsides: when someone exercises an option, they have to pay after-tax cash for the shares. Then, unless there is a simultaneous liquidity event, they have to hold onto the shares until a liquidity event occurs at some uncertain future date. They may also have to pay ordinary income taxes on the spread between the grant and strike price (on nonqualified options) or alternative minimum tax (in incentive options).

From the owners' standpoint, this seems like a great reward. Employees will have the chance to cash in big when a liquidity event (typically a sale of the company or, more rarely, an IPO) happens. From the employee's standpoint, there is current pain and uncertain future gain. We know from behavioral economics that most people overvalue costs and risks relative to potential gains, so they may see the award as more punishment than reward. Moreover, some employees may not see themselves staying until a liquidity event occurs, or will be uncertain whether one ever will occur. What will they do with their shares if the event doesn't happen or they leave before it? Will the company buy their shares at current value or just tell them to hold on to them? This uncertainty further erodes the value of the award.

Of course, the company could just buy the shares immediately. But in that case, why bother with the shares at all? A stock appreciation right accomplishes the same thing and leaves the employee with a net settlement, after taxes, of cash or shares. No pain, all gain.

There are two potential drawbacks, however. First, the company has to have resources to pay for the SAR at exercise (at the very least, to pay the taxes due if just shares are issued, but all the costs is cash is issued). Second, the employee typically has less flexibility in choosing when to exercise after vesting occurs, although it is possible to structure a deferral election into the process.